7 Questions to ask when assessing a company's readiness for the new lease accounting standards - IFRS 16 / FASB ASC 842
Although the 1st January 2019 implementation deadline may seem a lifetime away in terms of lease accounting impact, the time is already here to make sure you are fully aware of how to prepare for IFRS 16.
If you’re a company using FASB ASC 842 the deadline arrives a few weeks earlier, in the middle of December 2018. In order to comply with the changes and to mitigate the impact, especially those with larger lease portfolios, the work should start now.
Recap: The Changes That Are Coming
After years of planning and consultation, the world’s two leading accounting standards bodies, FASB and IASB, are changing the way that lease accounting needs to be recorded. As of mid-December 2018 (FASB compliant companies) and 1st January 2019 (IASB compliant companies), lessees are required to recognise an asset and liability arising from an operating lease on balance sheet. Under existing lease accounting principles (IAS 17 and FAS 840), operating leases are accounted for as ‘off-balance sheet’ treatments that are disclosed within the footnotes of an entity’s financial statements and therefore many assets and resulting liabilities are not accurately represented on financial statements. To counteract this, the new accounting standards aim to improve the accuracy and comparability of financial statements by bringing almost all leases on balance sheet.
But there are some exceptions to the rule and a lot of factors to consider in order to comply. Read on to see more.
What Companies Should Ask In Order To Prepare:
- How Many Leases Does The Company Have?
- How Many Are Interrelated Leases?
- What, If Any Of The Optional Lease Exemptions Will You Apply?
- Where Is Lease Data Stored?
- Who Manages Lease Agreements Within The Business?
- What New Leases Will Be Signed By 2019?
- What Impact Will The Changes Have On Your KPIs and Processes?
Before explaining, in more detail, why these questions need to be asked, you may wish to check out our free and helpful “7 Step Guide To Implementing The New Lease Accounting Standards”.
How Many Leases Does The Company Have?
The obvious starting point is to complete a full and thorough inventory of all the leases that the company is liable for. This exercise should capture the key data for each lease agreement, no matter how small or short, and even if the agreement ceases before the implementation deadlines. This is because some IFRS compliant companies may be required to issue retrospective balance sheets which are in line with what will be compulsory reporting rules from 1st January 2019 onwards.
What’s more, companies will also need to assess whether their existing leases should be classed as a lease under the new standards’ definition of what actually constitutes a lease. For businesses with an extensive lease portfolio, this will clearly be an enormous task.
For the avoidance of doubt, the implementation date for IFRS 16 is 1st January 2019 and for FASB ASC 842 it is 15th December 2018 for public companies and 15th December 2019 for all other entities. If you are a U.S owned company, it may be worth checking whether you need to comply with FASB regulation.
You should also identify which of your leases are respectively operating and finance leases if you are subject to FASB regulation. IFRS 16 will not differentiate between operating and finance leases.
How Many Are Interrelated Leases?
The changes in lease accounting will also require companies to show all related leased items together on-balance sheet. This reflects the true expenditure on a leased item which relies on other leased items in order to properly operate.
To explain, a certain piece of machinery may only be able to be used under certain conditions and alongside another leased item, like, for example, using a construction crane close to a public footpath which would require the erection of pedestrian or ‘heras’ fencing. These two leased items are interrelated and operate together, though may be leased through different suppliers. And they obviously have very different financial values, which is important when considering how to manage small ticket value items.
What, If Any Of The Optional Lease Exemptions Will You Apply?
When aiming to apply the new lease accounting standards, it’s important that organisations take their time when deliberating whether it is in their best interests to apply certain lease exemptions.
In a decision to improve the balance between the benefits of the new standards and the associated costs of compliance, the two boards have included several exemptions that lessees can elect to apply during the application of the new standards.
These exemptions will require a lessee to exercise significant judgment; particularly surrounding the new definition of a lease and the identification of lease and non-lease components (services – e.g. maintenance).
When applying the new standards, if a contract is, or contains a lease component, as well as a non-lease component, then the lessee must separate the contact elements and account for them as separate components accordingly. The components should be split and allocated based on a relative stand-alone price. If the exact price of the breakdown is unavailable, lessees have two options. Either to use an estimate based on observable information (e.g. a price based on an existing agreement’s breakdown or similar contract from the supplier) or to use the optional practical expedient. Using this latter method, lessees have the option to account for a lease component and any associated non-lease components combined as a single lease element.
Whilst it is possible for a service contract to contain a lease, an identified lease cannot be treated as a service. Also, if an entity chooses to use the practical expedient for one class of underlying asset, they must also use it for all other leases of this asset type.
Other notable exemptions organisations must consider, include, short-term leases (by class of asset) that cover 12 months or less, and low value leases (lease-by-lease basis) with a purchase value, when new, of less than $5,000 and not dependent upon, or highly interrelated with, other leased assets (the low-value exemption is only applicable to IFRS 16). If a lessee elects to apply these exemptions, lease payments are recognised as an expense over the duration of the lease term.
“IFRS 16 will not differentiate between operating and finance leases.”
Where Is Lease Data Stored?
Now is probably a good time to establish a central and well-controlled database with all of your lease information. All suppliers, terms and conditions, payment schedules, rental amounts, and durations should be sought out and put into one place. This will ease your reporting pain.
Who Manages Lease Data In The Company?
If different leased items are managed by employees from different respective departments, one point of responsibility should be established. This is where the central lease information database will come in handy because it will make populating and deciding what goes on balance sheet a lot simpler. An intelligent software, like Innervision’s LOIS, will ensure that there is a fully traceable audit trail, with multiple portfolios and user accounts. This means that, rather than having one person as a central point of management, the software acts as the central hub where all departments can input their respective lease data. Which will be vital for large businesses.
What New Leases Will Be Signed By 2019?
The respective department heads, when applicable, within the business should provide information on all future planned lease agreements. This should include the renewal of existing agreements which will be running past 1st January 2019 and any prospective agreements based on what projects are likely to be live in two years’ time.
If early tenders are underway and projects are looking likely to be secured, then these should be tentatively prepared to be included in future reporting on-balance sheet so that there are no surprises and nothing is misrepresented.
What Impact Will The Changes Have On Your KPIs and Processes?
The change to IFRS 16 is going to bring an estimated $2.8tn worth of assets on balance sheet. For some businesses, this move could drastically change their outward projections of how well the business is performing to investors, lenders and any potential buyers.
IFRS 16 Impact:
Income statements and profit performance reports will be impacted by the IFRS 16 changes. As will other key performance indicators that stakeholders rely on for communication and analysis, such as financial ratios. The International Accounting Standards Board (IASB) estimate that leases coming on balance sheet will increase EBITDA by 10%. At the same time, total assets are set to rise, thanks to the increased recognition of the right of use assets. Likewise, increases in EBIT and financial debt will come, along with an increase in the gearing ratio and operating cash flow. But equity ratio is set to decrease due to the higher financial debt and total asset turnover should also decrease.
FASB ASC 842 Impact:
This standard will see less of an impact, thanks to the fact that existing leases can still retain a separate classification between being a capital and operating lease. However, this does not stop asset turnover, return on assets and capital employed, quick ratios and net worth being decreased. It will also mean a recalculation of EBITDA and debt to equity ratio.
Changes to both standards will also impact existing loan credit ratings and future borrowing costs. With so many critical financial metrics and KPIs being impacted by the changes, it highlights how imperative it is that businesses are fully aware of how the new standards will impact their profit performance. However, to accurately do this, there is an increased need for companies to more closely manage their lease portfolio so they can accurately anticipate and forecast the shift in metrics.
The most efficient solution is to use a lease accounting software such as LOIS. This will make your reporting and management as pain-free as possible.
Find Out More About Lease Accounting Changes
In the meantime, you may wish to find out more about how to prepare for FASB 842 and IFRS 16. We have put together a FREE 7 step guide to becoming compliant, above and beyond the questions you need to ask yourself. Press the button below to get your free guide.
Warning: this article contains general information about the new lease accounting standards only, and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.